Rejoining the north European mainstream

By Professor Simon Deakin

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The campaign to increase the £6.19 an hour national minimum wage to a living wage of £8.55 in London and £7.45 in the UK should be supported on the grounds of both equity and efficiency. The living wage is good for families and workers, but also for firms and for the UK economy.

Joint research by the Resolution Foundation and the Institute for Public Policy Research has found that gross earnings would rise by £6.5bn if employees were paid a living wage. It also showed that paying UK workers a living wage would save the Treasury more than £2bn a year by boosting income tax receipts and reducing welfare spending.

This comes as no surprise to those who conduct research on public policy. If employers do not pay a living wage the state has to make up the difference through tax credits. These arrangements benefit no one except, possibly, firms which use tax credits as a pretext for paying low wages. These firms are more profitable as a result and their shareholders may also be better off. But their gains are being made at the direct expense of low-paid workers and the taxpayer.

The Council of Europe sets a decency threshold which implies that the minimum wage should be around two-thirds of the median wage (that is, the wage paid at the midpoint in the earnings distribution). The UK's national minimum wage has generally been around 45 per cent of the median wage since the late 1990s. The gap between the legal minimum and the decency threshold set by the Council of Europe has been met, in practice, by tax credits. This system has been allowed to develop because of fears that a high minimum wage would cause unemployment.

When the minimum wage was introduced in 1998, the Low Pay Commission was set up to advise ministers on its level. The commission was given the remit of determining what the likely economic effects of the minimum wage would be. Its membership consisted of a number of academic economists, in addition to representatives of management and labour. The outcome was a statutory minimum wage set at a level which did not meet families' living costs. To meet the gap, the then Labour government, which was committed to reducing household poverty, expanded the system of tax credits which it had inherited from the preceding Conservative administrations. This worked for a while. The rise in child poverty levels was reversed, but only up to the mid-2000s. The burden on public expenditure of increasing tax credits to make up for persistently low wages was becoming excessive.

The living wage campaign began as a response to adverse effects of low pay on many working households. These included very long working hours which were often spread over two or three separate jobs as earners attempted to meet living costs. Supporters of the living wage do not argue that it should become legally binding in the same way as the national minimum wage. Rather, they call on employers to recognise the principle of the living wage on a voluntary basis, and to make their position known to their contractors and suppliers, and to the public at large. The campaign is based on persuasion and an appeal to employers' enlightened self-interest.

Why would employers want to sign up to the living wage? The direct benefits include a more loyal and highly motivated workforce. Indirectly, employers with a stake in their local community may view the living wage as contributing to social cohesion. This is undoubtedly a factor in the support given to the living wage by many local authorities, hospitals and universities. But private sector employers in the retail and service sectors are also interested. There is a growing realisation that employers cannot insulate themselves from the social consequences of the decisions they make on wages and terms of employment.

What would be the effect of employers more generally accepting the principle of the living wage? Would it increase unemployment? This seems unlikely. One of the arguments for taking a cautious view on the level of the minimum wage in 1998 was that firms had come to rely on low pay as a means of cutting costs. The introduction of a high minimum wage would have been a shock to the economy, leading to increased unemployment. This argument has less resonance today. Employers have had over 15 years to get used to the minimum wage. As a result, the idea that wages should more reflect real living costs is becoming more generally accepted. Because the living wage is not mandatory, progress towards achieving it can be tailored to the circumstances of particular firms.

From the point of view of government expenditure, the living wage would be largely self-financing, thanks to the offsetting effects on tax credits. It would also bring wider benefits to the economy. The most productive economies in the world, those of the Nordic countries and the northern European systems influenced by the German model, either have high legal minimum wages or multi-employer collective agreements which set basic minimum rates of pay which are high by UK standards. These pay norms provide an incentive structure for investment by workers and employers in firm-specific skills. High minimum wages do not work on their own; they must be combined with other policies. These include active labour market policy to support the welfare-to-work transition such as in the Nordic countries, or the national vocational training system in Germany. Such measures might seem expensive, particularly during an economic recession. In fact, they largely pay for themselves once their impact on productivity is taken into account.

The living wage can be the basis for Britain to become a high-wage, high-productivity economy. We should aim to rejoin the north European mainstream on this issue. Looking further overseas, the very last thing we should be doing, if we wish to compete with the BRIC countries, is further deregulating our labour market. Brazil is addressing the issue of informal employment by putting a floor under household incomes through a basic income guarantee, while China has adopted a labour code which acknowledges the need for protection of individual and collective labour rights. These developing economies are gradually building systems of collective wage determination and social insurance of the kind we used to have. They understand that a competitive economy requires labour laws and a welfare state to provide insurance against labour market risks. We have not completely abandoned the same idea, which served us well for most of the 20th century. It is not too late to reconstruct our labour market institutions around the twin themes of equity and efficiency, as exemplified by the idea of the living wage.

Also posted on Progressonline

Shares for Workers' Rights - why entrepreneurial firms need employment law too

By Professor Simon Deakin

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Under the government's current proposals for employment law reform, employees will be able to give up rights concerning unfair dismissal, redundancy pay, flexible working and time off for training in return for receiving shares in the company that employs them, gains on which will be exempt from capital gains tax.

It is right for the government to be encouraging worker ownership in companies; there is abundant evidence suggesting this improves labour productivity. What is completely unnecessary and counterproductive is to link this to the loss of employment protection rights.

Since the early 1970s, under laws initially introduced by a Conservative government, an employee with a minimum period of continuous service (currently two years) is protected against unfair dismissal. This means that if their employer wishes to terminate their employment, they must come up with a good reason, in principle, for doing so, such as misconduct, lack of capability or redundancy. The employer must also show that it has complied with certain procedures, including allowing the employee to put their case in a formal hearing. These laws do not confer a job for life and in no way permit "featherbedding". On the contrary, they give employers ample scope to incentivise and motivate employees. Nor do they prevent firms making workers redundant when there is a downturn in business. Their aim is to ensure that the workplace operates according to certain basic principles of fairness, which most of us could subscribe to: decisions on a matter as important as employment should not be made in an arbitrary fashion.

Although fairness is the main goal of these laws, they also have economic effects. They encourage workers to make a more serious commitment to the firm and to invest their time, effort and loyalty in it. Second, they provide firms with a strong incentive to treat the skills of their workers as a resource to be developed, rather than an asset to be disposed of at will. Employment protection laws encourage a virtuous cycle of investment in the knowledge and processes that are increasingly recognised as essential to economic success, particularly in high-technology sectors.

One of the government's aims in bringing forward this proposal is to encourage the kind of high-tech start ups associated with Silicon Valley in California. Silicon Valley is often said to have a "high velocity" labour market, in which employees move around from one firm to another, thereby promoting the circulation of knowledge. Employers, on the other hand, benefit from the flexibility that goes with having a skilled and mobile workforce. It is often assumed that the right of firms to hire and fire "at will" is critical to this type of flexibility. There is a major problem with this assumption, which is that it is simply not borne out by the facts.

The Californian law on dismissal is actually at the stricter end of the spectrum of US laws on employment. The principle that an employer can dismiss at will – that is, without good cause and on minimal, if any notice – has been qualified by the Californian courts, which require employers to demonstrate that they have acted in good faith when terminating a worker's employment. This principle is not so far removed from the notions of fairness that underpin British unfair dismissal law. The scope of the exceptions to employment at will have waxed and waned over the years, and it is possible to analyse the consequences of this for productivity and innovation. We know from econometric research that there is a correlation between tighter dismissal laws and innovation in California, as measured by increased number of patents and citations to patents. Not just that; as the law imposed constraints on the employer's power to dismiss, the number of small-firm start ups went up, as did the numbers employed in high-tech firms.

British dismissal law, like Californian, has varied over time, creating a similar "natural experiment" for research. The identical effect is also observed: stronger employment laws are correlated with innovation as measured by patents and citations to patents.

The intuition here is clear, and it is backed up by empirical research: when the law limits the right to dismiss, it enhances the confidence of workers that their efforts and knowledge will not be expropriated by the employer. The law can help to create an environment in which firms and workers make mutual investments in new technologies and processes, to the benefit of both sides.

Employment law plays another critical role in supporting technology-based innovation in US firms. In California, so-called "restrictive covenants" that prevent an employee resigning to set up his or her own firm or to work for a competitor are void. Californian courts refuse to enforce such clauses, on the grounds that they are a fetter on competition. This, rather than flexible dismissal laws, is the source of the much-vaunted "high-velocity labour market" of Silicon Valley. How does the UK compare? Under English contract law, contrary to the Californian practice, restrictive covenants are enforced by the courts almost as a matter of routine. We know this matters. When the state of Michigan changed its employment laws to make restrictive covenants enforceable, it saw a decrease in employee mobility.

So if the British government wants to do something to encourage innovation through employment law reform, there are two things it could do. The first would be to strengthen laws that promote fairness in the workplace. The second would be to take a closer look at judicial enforcement of restrictive covenants. There is clear evidence that these contract clauses restrict employee mobility and depress innovation.

Compared with these changes, which empirical evidence suggest would have a tangible effect, the proposed reforms are at best an irrelevance. At worst, they will set back innovation in British high-tech firms.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university

Also posted on FT's Economists' Forum